Europe's Road to Nowhere, Part 2

Over the next few months, the eurozone faces a number of challenges, including the implementation of the new arrangements, possible further downgrading of nations, refinancing maturing debt, and meeting required economic targets.

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Over the next few months, the eurozone faces a number of challenges, including the implementation of the new arrangements, possible further downgrading of a number of nations, refinancing maturing debt, and meeting required economic targets.

No to Implementation

Implementation of the new fiscal compact may not be a fait accompli. Delays and changes cannot be ruled out.

At least four governments have indicated that agreement to the changes is contingent on the precise legal text. One key area of concern is the precise form and extent of powers granted to the EU to police national budgets. Another relates to the structure of the ESM, where a qualified majority of 85% will have the power to make emergency decisions. Finland is currently opposed to the ESM act by super majority instead of unanimity. Others are also reluctant to pay in capital, which can be placed at risk without the right to a veto.

In the background, negotiations on the Greek package of July 2011 have also stalled. There is a risk that a significant number of banks will refuse to participate in the complex debt restructuring, entailing a write-down of 50% of private debt.

Following a review, S&P has downgraded France and Austria from AAA to AA+. The rating agencies may follow. The risk of further downgrades exists. The European bailout fund is under threat of being downgraded, as the number of AAA rate guarantors backing it has fallen from 451 billion euros to 271 billion euros (a fall on 40%). This weakens its already compromised ability to raise funds to meet existing commitments to Greece, Ireland, and Portugal and to support the funding of other countries.

Wall of Debt

A crucial issue is the ability of European sovereigns to meet maturing debt commitments and to keep borrowing costs at a sustainable level.

European sovereigns and banks need to find 1.9 trillion euros to refinance maturing debt in 2012. Italy requires 113 billion euros in the first quarter and around 300 billion euros over the full year.

European banks, whose fates are intertwined with the sovereigns, need 500 billion euros in the first half of 2012 and 275 billion euros in the second half. They need to raise 230 billion euros per quarter in 2012 compared to 132 billion euros per quarter in 2011. Since June 2011, European banks have been only able to raise 17 billion euros compared to 120 billion euros for the same period in 2010.

Given that banks and investors have been steadily reducing their exposures to European countries and banks, the ability to finance this wall of debt is uncertain. The bailout fund and the IMF with around 200 billion to 250 billion euros each cannot absorb this issuance.

Europe will be forced to resort to "Sarko-nomics" to finance itself -- European banks purchase sovereign debt, which is then pledged as collateral to borrow unlimited funds from the ECB or national central banks.

This perpetuates the circular flow of funds with governments supporting banks that are in turn supposed to bail out the government. It does not address the unsustainable high cost of funds for countries like Italy. If its cost of debt stays around current market rates, then Italy's interest costs will rise by about 30 billion euros over the next two years,from 4.2% of GDP in 2011 to 5.1% currently and 5.6% in 2013.

Debt reduction through restructuring remains off the agenda. The adverse market reaction to the announcement of the 50% Greek write-down forced the EU to assure investors that it was a one-off and did not constitute a precedent. Despite this, investors remain sceptical, limiting purchases of European sovereign debt.

Reality Check

The prospects for the real economy in Europe are uncertain.

For the nations that have received bailouts, the austerity measures imposed have not worked. Growth, budget deficit, and debt level targets have been missed.

Greece has an 14.4 billion euro bond maturing in March 2012. Prime Minister Lucas Papademos must meet existing targets and agree to the second Greek bailout worth 130 billion euros by the end of the month, before scheduled elections, to allow official funding to be available to refinance this debt.

Ireland, the much-lauded poster child of bailout austerity, has experienced problems. The country's third-quarter GDP fell 1.9%. Ireland must reduce its budget deficit from 32% of GDP in 2010 to 3% by 2015. Despite spending cuts and tax increases, Ireland is spending 57 billion euros, including 10 billion euros o support its five nationalized banks, against 34 billion euros in tax revenue.

Spain's economic outlook is poor and deteriorating. Spain's budget deficit is above forecast (at 8% of GDP, it is a full 2% above the target agreed with the EU), and the need for support of the Spanish banking system may strain public finances further. Unemployment increased to over 21% (nearly 5 million people).

Under Prime Minister Maria Monti, Italy has passed legislation and budget measures to stabilize debt. The actions focus on increasing taxes, especially the regressive value-added tax, rather than cutting expenditures. Structural reforms to promote growth are still under consideration, and the content and timing is unknown. It is also not clear whether the plans will be fully implemented or work.

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